Second-Term Realities

Now that was something else... For the week, the Dow gained 3.6% and the S&P500
rose 3%. Economically sensitive issues were on fire (as were many non-economically
sensitive). The Transports gained 3%, increasing y-t-d gains to almost 19%.
The Utilities added 2%, with 2004 gains of 17%. The Morgan Stanley Cyclical
index jumped 6% to an all-time high (up 7% y-t-d). The Morgan Stanley Consumer
index rose 4%. The broad market was quite strong. The small cap Russell 2000
surged 3.5%, and the S&P400 Mid-cap index gained 3%. The NASDAQ100 rose
2.6%, and the Morgan Stanley High Tech index advanced 3%. The Semiconductors
and NASDAQ Telecommunications indices each added 1%, and The Street.com Internet
index gained 2%. The Biotechs jumped 4%, increasing 2004 gains to 9.4%. The
Broker/Dealers jumped 5%, and the Banks gained 3%. Bullion traded up $5.0 to
a 15-year high $433.55. The HUI gold index gained 2%.

November 5 - Bloomberg (Bharat Ahluwalia): "Indian 10-year bonds fell, pushing
yields up by the most in 18 months, on speculation banks will buy less debt
at a sale Nov. 8 after their surplus cash shrank. As funds with lenders dropped,
bonds fell for the fifth day in six, and the central bank moved to address
the shortage by adding money to the banking system for the first time since
March 28, 2003... Demand also slid on concern inflation may accelerate after
India's oil refiners raised fuel prices yesterday."

Freddie Mac posted 30-year fixed mortgage rates rose 6 basis points this week
to 5.70%. Fifteen-year fixed mortgage rates were up 7 basis points to 5.08%.
One-year adjustable-rate mortgages could be had at 4.00%, up 4 basis points
for the week. The Mortgage Bankers Association Purchase application surged
12% last week to the highest level since the first week of July. Purchase applications
were up about 23% from one year ago, with dollar volume up 38%. Refi applications
increased 3% during the week. The average Purchase mortgage dipped to $224,000,
while the average ARM increased to $309,000. ARMs accounted for 34.4% of total
applications last week.

This week's ABS issuance amounted to about $12 billion (from JPMorgan).
Total year-to-date issuance of $535 billion is 38% ahead of comparable 2003.
2004 home equity ABS issuance of $338 billion is running 80% ahead of last
year's record pace.

November 5 - Bloomberg (Julie Ziegler): "China said it's concerned that
eliminating its nine-year-old currency peg might trigger capital inflows
at a time when the country is trying to cool the economy, according to
the International Monetary Fund."

The euro ended today at an all-time high of 1.2964 against the dollar. The
dollar index declined 1% this week to a near 9-year low. The "commodity" currencies
enjoyed a strong week, with the Chilean peso up 2.4%, Australian dollar 1.9%,
and New Zealand and Canadian dollars 1.6%. The dollar mustered a 0.6% gain
against the Nigerian naira and 0.9% rise versus the Uruguay peso, and that
was about it.

Commodities Watch:

November 4 - Bloomberg (Loretta Ng and Vicki Kwong): "China's crude steel
consumption may rise as much as 39 percent between 2005 and 2010 to 330 million
metric tons, according to one of India's largest exporters of iron ore. China's
steel needs should reach at least 237 million tons next year..."

With December crude declining $2.15 to a $49.61, the Goldman Sachs Commodities
index declined 3.8% for the week. This reduced year-to-date gains to 30.9%.
The CRB index was unchanged on the week, with y-t-d gains of 11.1%.

China Watch:

November 1 - XFN (Claire Leow): "China's economy will grow 8-8.5% year-on-year
in 2005, according to a government think tank... 'Considering slowing investment
and cooling export growth, China's GDP growth will slide to 8-8.5% next year,'
said the National Development and Reform Commission's (NDRC)... The NDRC report
predicts an 18% growth in investment next year, with consumer price index growth
of about 3%, and retail sales -- after being adjusted for inflation -- up about
9.5%."

November 3 - Bloomberg (Jianguo Jiang): "The worst drought in half a century
in southern China has caused 4 billion yuan ($483 million) in economic losses
and reduced water supply for 7.2 million people, the Xinhua news agency said..."

November 2 - Bloomberg (Koh Chin Ling): "China will need to add 2,194 new
planes in the next two decades to meet demand for air travel, the China Daily
newspaper reported, citing Liao Quanwang, vice-director of the Aviation Industry
Development Research Centre of China. China's expected to more than triple
its passenger planes to 2,373 from 664 in the period through 2023..."

November 2 - Bloomberg (Janet Ong): "China's top foreign-exchange regulator
said it will step up a crackdown on 'speculative capital inflows' to preserve
financial stability, seeking to deter bets on a yuan revaluation after last
week's interest rate increase. Illegal foreign-exchange settlements by some
banks and companies are hampering government efforts to cool growth in the
world's seventh-largest economy, the Beijing-based State Administration of
Foreign Exchange said..."

Asia Inflation Watch:

November 4 - Bloomberg (Rob Stewart): "JPMorgan Chase & Co. Chief Executive
Officer William Harrison said he plans to expand in India, where the government
and local companies sold a record $7.1 billion of stock this year and competitors
including Merrill Lynch & Co. already have local ventures. 'The momentum
here is good,' Harrison, 61, said... 'As Asia grows, we will continue to build
our business here.'"

November 5 - Bloomberg (Cherian Thomas): "India's inflation rate accelerated
more than expected in the third week of October as food and fuel prices rose,
adding pressure on the central bank to raise interest rates. Bonds extended
earlier losses. Wholesale prices rose 7.38 percent from a year earlier..."

November 5 - Bloomberg (Cherian Thomas and Kartik Goyal): "India's Finance
Minister P. Chidambaram said the country can raise its economic growth rate
to an 8 percent pace over the next decade..."

November 5 - Bloomberg (Theresa Tang and James Peng): "Taiwan's foreign-currency
reserves, the third-highest in the world, rose in October for a 40th month
to a record $235 billion... The reserves, which rank behind those of Japan
and China, rose from $233 billion in September..."

November 2 - Bloomberg (Stephanie Phang): "Malaysian exports rose at their
fastest pace in nine months in September, boosted by record shipments of oil
and commodities and a rebound in electronics sales to China. Exports jumped
29 percent from a year ago to 44.4 billion ringgit ($11.7 billion)..."

November 1 - Bloomberg (Seyoon Kim and Heejin Koo): "South Korean exports
rose in October at their slowest pace in 11 months and growth may ease further
in coming months as won strength makes the nation's products more expensive
overseas, the commerce ministry said. Exports rose 21 percent from a year earlier
after climbing 23 percent in September..."

November 5 - Bloomberg (Francisco Alcuaz Jr. and Jun Ebias): "Philippine inflation
accelerated to a five-year high in October as record crude oil costs pushed
prices higher. Central bank Governor Rafael Buenaventura said interest rates
are unlikely to be raised to curb price gains. The consumer price index rose
7.1 percent from a year earlier..."

November 1 - Bloomberg (Claire Leow): "Indonesia's exports rose more than
twice as fast as analysts expected in September, boosted by higher oil prices
and shipments of palm oil, nickel and coal. Exports rose 41 percent from a
year earlier to $7.15 billion, the highest since Indonesia's recession in 1998..."

Global Reflation Watch:

November 4 - ECB President Jean-Claude Trichet: "Persistently high and rising
oil prices have had a visible direct impact on consumer prices this year, and
inflation is likely to remain significantly above 2% in the coming months.
This is a worrisome development, but there is no strong indication as yet that
medium-term inflationary pressures are building up in the euro area. In particular,
wage growth appears to remain limited, in the context of ongoing moderate real
GDP growth and weak labor markets ... However, there are upside risks to price
stability over the medium term. Strong vigilance is therefore warranted with
regard to all developments which could increase such risks..."

November 5 - Bloomberg (Edward Evans): "U.K. demand for workers increased
to its highest since January 2001 in October as skills shortages rose to their
highest in seven years..."

November 1 - Bloomberg (Ben Holland): "Turkey's exports climbed 20 percent
in October from the same month last year, according to preliminary figures
announced by the Turkish Exporters' Association. The country had exports of
$5.91 billion in September... Exports in the first nine months of the year
rose 32 percent to $51.5 billion..."

November 4 - Bloomberg (Adriana Arai): "Mexico will keep raising interest
rates after seven increases this year to push down an inflation rate that has
climbed to a 17-month high, central bank Deputy Governor Jesus Marcos Yacaman
said."

November 4 - Bloomberg (Romina Nicaretta): "Brazil's government raised its
growth forecast for next year as an expected drop in domestic interest rates
will fuel growth in South America's biggest economy... Brazil's Finance Ministry
raised the country's growth forecast for 2005 to 4.3 percent from a previous
forecast of 4 percent..."

November 5 - Bloomberg (Adriana Arai): "Chile's economy grew 7.7 percent in
September from a year earlier, spurred by stronger spending at home and demand
for exports abroad."

November 2 - Bloomberg (Dylan Griffiths): "South African vehicle sales rose
23 percent in October from the same month last year, as the lowest interest
rates since 1981 boosted consumer and business spending, an industry group
said."

Bubble Economy Watch:

October 31 - Dow Jones): "The most expensive presidential advertising campaign
in history closes Tuesday after eight months with President Bush, Sen. John
Kerry, their political parties and allied groups having spent more than
$600 million. That's triple the amount spent on TV and radio commercials in
2000."

November 4 - Bloomberg (Brendan Murray and Simon Kennedy): "The U.S. current
account deficit, which reached a record $166.2 billion in the second quarter,
reflects international investment and low U.S. savings, said John Taylor,
the U.S. Treasury's undersecretary for international affairs. Faster
economic growth and more flexible currencies overseas along with a lower
federal budget deficit and higher U.S. savings will help narrow the gap,
Taylor told a conference in Washington. 'When investment in the United
States is higher than domestic saving, foreigners make up the difference
and the United States has a current account deficit,' he said. The deficit
in the second quarter was equivalent to 5.7 percent of the nation's $11.6
trillion economy, up from 5.1 percent in the first quarter. The U.S. needs
to attract about $1.8 billion a day in foreign capital to plug the shortfall."

November 4 - Bloomberg (Karen Brettell): "Two-thirds of leveraged loans issued
in the U.S. primary market are packaged into structured products known as collateralized
debt obligations, said Standard & Poor's. 'CDOs are driving the whole
leveraged-loan industry at the moment,' said Richard Gugliada, managing
director of structured finance... CDOs that bundle leveraged loans are in strong
demand, though the scarcity of the credits in the primary market is posing
challenges for them... Banks create CDOs by packaging assets and using income
on the debt to repay investors. They may be leveraged and offer higher returns
than their underlying securities. Issuance of loans by U.S. institutions rose
to 114 in the third quarter of this year, compared with 65 at the same time
last year, and a 2003 total of 91 loans, S&P said."

November 3 - Bloomberg (Dianne Finch): "Property insurers paid a record $21.3
billion in third-quarter claims following four hurricanes, the Associated Press
reported, citing New Jersey-based Insurance Services Office Inc. Property-loss
claims relating to eight disasters including Hurricanes Charley, Frances, Ivan
and Jeanne exceeded claims of $3.7 billion in the same period a year earlier,
$715 million in 2002, and $19.15 billion in 2001..."

November 2 - The Wall Street Journal (Jane E. Kim): "At a time when health-care
costs are continuing to climb at near-double-digit rates, more Americans are
being forced to cut back on their retirement savings and make lifestyle changes
to pay for medical care, according to a new survey. About one-quarter of U.S.
households that have experienced growing medical bills have reduced their retirement-savings
contributions, while nearly half have reported cutting back on their other
savings... Nearly 20% say medical bills are making it more difficult to pay
for necessities such as food and housing, while one-quarter say they are close
to tapping out their savings to pay such bills."

November 4 - Dow Jones: "A new survey indicates the number of foreign graduate
students enrolling for the first time at American universities is down 6% this
year -the third straight decline after a decade of growth. Educators worry
the trend is eroding America's position as the world's leader in higher education."

Mortgage Finance Bubble Watch:

November 3 - Freddie Mac: "In the third quarter of 2004, 60 percent of
Freddie Mac-owned loans that were refinanced resulted in new mortgages at
least five percent higher in amount than the original mortgages, according
to Freddie Mac's quarterly refinance review. This is in contrast to the second
quarter of 2004, when 42 percent of refinanced loans had higher new loan
amounts... Based on our October outlook for mortgage originations and
refi activity in 2004, we expect the amount of home equity cashed-out
to total $118 billion. Total equity cashed out in the third quarter is
estimated at $41 billion, up from the estimated second quarter cash-out amount
of $28.5 billion... The Cash-Out Refinance Report also revealed that properties
refinanced during the third quarter of 2004 experienced a median house-price
appreciation of 17 percent during the time since the original loan was made,
up considerably from the seven percent appreciation on loans refinanced in
the second quarter. For loans refinanced in the third quarter of 2004,
the median age of the original loan was 2.6 years..."

November 3 - Honolulu Star-Bulletin (Allison Schaefers): "While many say Oahu's
residential real estate market is showing signs of cooling, demand was still
hot enough last month to spark record highs for asking prices and sales prices
of single-family homes. The median asking price of single-family homes climbed
in October to $675,000, a year-on-year gain of 22.7 percent. Meanwhile, the
median resale price of a single-family home on Oahu rose 21.5 percent to $485,000
last month, according to monthly sales data from the Honolulu Board of Realtors."

Earnings Watch:

November 3 - Dow Jones (Dawn Kopecki): "Freddie Mac won't provide investors
with timely financial statements until early in 2006, postponing registration
with the Securities and Exchange Commission until the middle of that year
at the earliest, executives said... The $1.5 trillion mortgage finance
company hasn't reported its financial results on time since late 2002 after
Freddie replaced auditor Arthur Andersen with PriceWaterhouseCoopers, which
found widespread accounting problems at the company and forced it to restate
several years of earnings. Freddie has delayed its statements to sort out
its accounting problems and revamp internal systems, something Chief Executive
Richard Syron said still needs a lot of work."

Subprime mortgage lender New Century Financial reported quarterly earnings
of $107.3 million, up 65% from 2003's comparable quarter. Total Assets expanded
at a 31% rate during the quarter to $15.9 billion. Assets have more than doubled
over the past year and have increased from $2.8 billion to end last year's
first quarter. The company has completed its transformation to a REIT, while
ending the quarter with Shareholder's Equity of $818 million.

Second-term Realities

Vice President Cheney spoke confidently of having won a broad national "mandate," while
President Bush exclaimed, "I earned capital in the campaign, political capital,
and now I intend to spend it." There is no reason to doubt that the Administration
will forcefully pursue its ambitious agenda. The President and his team are
empowered, with an overarching goal of a second term worthy of an historic
legacy. It is, as well, rational that they would today edge toward overconfidence
and complacency when it comes to the great risks they will confront during
the next four years.

I have no intention to attempt what would surely be amateur political analysis,
and I am an analyst and not a partisan. There is no shortage of political insight
and pontification these days. Yet I do see a dearth of cogent analysis of the
financial, economic and social backdrop that will play a profound role in the
political process as we go forward. We witnessed an incredible campaign of "guns
and butter" from the opposing parties, heavy on promises and featherweight
on economic realities. And now the undoubting victor will attempt to lead a
deeply divided nation on an aggressive course in an environment fraught with
significant and myriad risks - some discernable.

Never before have financial markets played such a central role in society.
More are exposed to marketable securities; more giddily play the mortgage and
housing markets; and more have their retirement tied directly to the stock
and bond markets. And never before have so many livelihoods been associated
with financial and real estate asset prices. The melding of politics to wealth
creation - in this case financial wealth - is an innate process, and fanciful
notions of an "ownership society" do indeed captivate while in the bosom of
an historic asset Bubble. I believe it is reasonable to suggest that had the
stock market not recovered, had mortgage rates not dropped to record lows,
and had home prices not inflated significantly, the political agenda today
would be altogether different. I don't think one can exaggerate the profound
political and social effects of The Great Reflation. And with no intention
of being flippant, I do not expect gay marriage to be a major issue in 2008.

In my mind, there is a paramount analytical issue to contemplate: The Bush
administration today ardently believes that their policy choices were responsible
for what has developed into sustainable economic recovery. And having persevered
through a stock market scare, technology collapse, recession, 9/11, Enron and
corporate malfeasance, a sinking currency and going to war, there must now
be great faith that a much more favorable financial and economic backdrop exists
to bless their aggressive agenda. Yet the reality of the environment is not
as perceived, and this fact of life will not be efficiently recognized: An
historic reflation, inciting "blow-off" Credit Bubble excess, was the dominating
feature of the second-half of President Bush's first term. It is, moreover,
at best unsustainable.

It is this evening worth recalling the backdrop that greeted the 2001 inauguration.
Fed funds began the year at 6.5%. The late-90s boom had filled the Treasury's
coffer, with talk of a Trillion dollar surplus and a coming shortage of government
debt instruments. Gold, at $270, was near a multi-decade low. The CRB commodities
index began the year at about 230, down from the 1996 high of about 260 and
about where the index stood in 1990 (and significantly below 1980!). Crude
oil traded near $27. With Asian, Latin American and other "developing" Credit
systems still afflicted with post traumatic stress disorder, liquidity was
at a premium for many economies and markets. Global price pressures were generally
more forceful to the downside. The dollar index was at about 110, with more
than a year remaining of its King Dollar ("blow-off") run to 120, while the
fledgling euro had stumbled badly out of the blocks.

The global appetite for U.S. securities was for all purposes insatiable, with
faltering demand for tech stocks instantaneously more than compensated by a
newfound lust for (Greenspan) bonds. American financial assets enjoyed a strong
inflationary bias when compared to vulnerable global goods, commodities and
securities markets. High quality bonds were about to enjoy an historic rally,
the speculative instrument of choice for playing the Greenspan Fed's too-well-telegraphed
strategy for responding to the bursting of the equity market Bubble. GSE debt
had come into its own as a higher-yielding and highly-liquid near-perfect substitute
for Treasuries.

Importantly (and oh so clear in hindsight), the U.S. system in 2001 enjoyed
considerable flexibility and capacity to absorb continued Credit and speculative
excess without traditional inflationary effects. Indeed, the spectacular "blow-off" throughout
the technology sector fogged the analysis that the Credit system and economic
Bubbles had room to run. With respect to the real economy - and paralleling
global imbalances - some sectors had been starved for finance as liquidity
mindlessly inundated tech and telecom.

There was back in 2001 extraordinary capacity for government spending stimulus,
while the Fed was heavily armed and poised for historic monetary stimulus.
After years of strong expansion, the mortgage finance super-sector was quite
well positioned for spectacular excess (waiting only for the next round of
reflation, and for homeowners to appreciate that homes, and not stocks, always
went up in price). Similar and not unrelated dynamics were in play with respect
to the ballooning global "leveraged speculating community." And with a strong
("King dollar") bias to own U.S. securities - speculative and otherwise - heightened
liquidity (domestic and global) would conveniently rush to purchase Treasuries,
agencies, U.S. corporate bonds, MBS and structured products (reminder: "Liquidity
Loves Inflation"). This basically gave the U.S. government, Federal Reserve,
GSEs, Wall Street and the financial sector, generally, blank checks for which
to stimulate and reflate. Especially when the global technology Bubble burst,
the Greenspan-commanded U.S. bond market became "the only game in town" for
an increasingly powerful speculating community.

With bond vigilantes an extinct species, The Game quickly evolved into a mad
dash to leverage the most liquid and inflating asset in the world - U.S. long-term
debt instruments - affording absolutely no constraints on over-issuance. Resulting "excess" global
dollar liquidity was a misnomer, as it was readily "recycled" right back to
profit from The Great Yield Collapse. There was even fancied talk of Argentina
and other "developing" economies switching completely to dollar-based monetary
regimes.

Many things are less than clear these days, but the stark contrast between
the backdrops from 2001 and the soon to commence 2005 should not be one of
them. Year-2001 provided the capacity - fiscally and monetarily - for an historic
reflation, with a quite atypical global financial and economic backdrop that
would prove amazingly accommodative to gross U.S. excess. A strong case can
be made as to the aberrational characteristics of the King Dollar period. Importantly,
few at home or abroad perceived that there were risks associated with U.S.
reflationary policies, and no one protested. Many were keen to the windfall
profit opportunities in financial assets.

These days, oil and energy markets trade at all-time highs, the euro at a
record, the dollar index at a multi-year low, gold at a 16-year high, the CRB
index not far off all-time highs. Foreign equity and bond markets are outperforming
their dollar-denominated counterparts. Most significantly, the U.S. economy
and financial markets now face the uncertain and problematic downside of an
historic reflation - the mirror image of 2001's promising upside. The Fed is
hopelessly behind the curve, bond yields have overshot on the downside, and
equity prices have become distorted to the upside from reliquefication-induced
inflated profits and excess marketplace liquidity. Real estate prices are generally
over-heated, with California and other upper-end markets demonstrating dangerous
Bubble excess. Mortgage finance demonstrates uncomfortable parallels to NASDAQ
1999. And while not yet appreciated, manic over-expansion and excess have destroyed
profit opportunities for the bloated U.S. financial sector and leveraged speculating
community. The initial light breeze of developing Credit system headwinds has
made landfall.

Of more immediate concern, Monetary Disorder is fostering increasingly unstable
markets. The bond market succumbed to distortions, speculative excess, and
a more recent short-squeeze and is now vulnerable to a destabilizing jump in
rates. And even today's strong employment data and rate rise could not slow
the dollar's descent. The stock market has lunged higher in a bout of euphoria,
hedge unwinding, and short-covering. Extrapolations and daydreams of protracted
bull markets are setting the stage for disappointment and worse.

And unlike 2001 or even 2003, there is today a growing list of parties fully
recognizing that they are being hurt be inflation. From drivers to homeowners
to businesses, energy costs are biting. Housing affordability has become a
major issue for millions; the cost and availability of medical care for tens
of millions.

Importantly, the weak dollar has become a cause for serious concern. Asian
central bankers are rightfully nervous, as surging energy and commodity costs
along with unwieldy liquidity create great inflation and economic uncertainty.
The ECB is on guard to heightened inflationary pressures, appreciating the
risks associated with prolonged energy and commodity price inflation in the
event of continued dollar weakness. Expect European political leaders to become
increasingly vocal critics of U.S. budget and trade deficits. No longer will
our Credit inflation and dollar devaluation go unnoticed or be appreciated.
Blather that our massive current account deficits are caused by foreign inflows
and the attractiveness of U.S. investment will not go unanswered.

Reiterating analysis from previous Bulletins, history provides some clarity
with regard to the nature of inflation cycles: once unleashed, inflation becomes
only more difficult to control and there are always hopes that just a little
more will suffice. Few initially recognize the eventual costs, while many clamor
and yearn for the perceived benefits. Politicians adore inflation, at least
until their constituents learn to abhor it. Over time inflation's losers become
more attentive and the detriment more conspicuous. For society as a whole,
the insidious effects of debt and inflation spawn angst, animosity, and polarization.
Globally, the redistribution of wealth foments acrimony and conflict.

Today, our administration is understandably ecstatic with the prospect of
four more years. And they would surely be content with four additional years
of reflation and attendant dollar debasement. But our foreign creditors are
being impaired and must be losing patience. Meanwhile, global central bankers
are coming to grips with the prospect of ongoing dollar weakness and the associated
increasingly unwieldy liquidity and pricing environment. Monetary Disorder
has become manifest. And, let's not forget, the U.S. bond Bubble. It appears
the transition away from the aberrational "the weak dollar is good for bonds" period
has begun, with unclear but potentially significant consequences. Myriad issues
for bond holders now include foreign selling, rising risk and inflation premiums,
speculative unwind, derivative-related selling and policymakers much more attune
to the needs of the economy and stock market.

Why do I have the sense that it is only a matter of time until the administration's
agenda is placed on the back burner to deal with more pressing issues such
as financial and economic instability, or even the dollar's role as the world's
reserve currency? The scenario I find most troubling is an oblivious policymaking
team steadfast in its pursuit of a legacy, stubbornly refusing to accept reality,
and in no position or having any inclination to cooperate with our global partners.
And it is a tragedy that our nation will face its next crisis so ill-prepared
and polarized, and in this regard there is certainly plenty of blame to spread
around.